Sunday, January 15, 2006

Demand Destruction: Who Gets Destroyed?

Economists who comment on the possible effects of world peak oil production love to ridicule those who make statements such as "demand at some point will exceed supply." Strictly speaking, those economists are right that supply and demand are always in balance. The variable that changes to make it so is price.

So an economist who accepts the possibility of an oil peak may still believe that the marketplace will allow us to make a relatively smooth transition to a new energy economy as the price encourages the development of alternatives to oil and as demand is destroyed. The latter phrase is often glossed over. But demand destruction is at the core of misconceptions by economists about the likely course of events leading up to and following an oil peak.

A smooth transition away from oil mediated entirely by market prices essentially assumes two things: 1) a very gradual decline in oil supplies after the peak and 2) a recognition in the market price that the peak is coming long before it arrives.

Both assumptions are called into question by Robert Hirsch's study of oil depletion curves in various countries across the globe. Hirsch's study indicates that any world peak is likely to have a sharp crest followed by a swift decline in oil production--anywhere from 3 percent to 13 percent per year if the historical record can be relied upon. Hirsch also notes that "in all cases, it was not obvious that production was about to peak a year prior to the event." This would help explain why the second assumption listed above is likely to turn out to be wrong as well. Market participants are unlikely to see the peak coming. This means that prices will only start to signal that alternatives are needed for oil long after it is too late to prevent tremendous disruptions.

Douglas Reynolds gives a more detailed explanation of how energy and other mineral markets misinterpret price signals as indicative of future supplies. When finite mineral resources are involved, the market typically creates "the appearance of decreasing scarcity," something I've commented on previously in Faith-based economics II: The case of oil's sudden scarcity.

The final argument on which the smooth transition idea rests brings us back to demand destruction. An economist will properly point out that people will stop using oil for some applications and will turn to alternatives where they are available. All that is true enough. But it is worth asking what they mean by "applications." In reality, it is the poor who will stop using oil for "some applications," both in industrialized countries and across the world. If alternatives are not available or are just as expensive, they will simply have to forgo the benefits of those "applications." That will help keep a lid on oil prices, but it won't solve the problem: too little oil for all the activities that power and feed 6 billion people.

With a sudden decline in oil availability it is almost certain that agriculture, which is heavily dependent on oil and oil derivatives, will be less productive; that many marginal factories will close in short order; that tremendous financial turmoil will occur in world markets; that many people will have to do with less heat or without heat at all; that skyrocketing prices for transportation will prevent commodities including food from freely circulating around the world, and so on. In short, there would be no smooth transition.

The heightened price of oil would certainly encourage conservation--i.e., demand destruction--but that conservation might come in the form of terrible hardship for millions and perhaps billions of people and possibly death for many. That would give a rather gruesome connotation to the notion of demand destruction. High prices would also encourage the development of alternative energy sources, but that's assuming that world society does not become so disoriented and chaotic that such efforts cannot actually be effected.

If one assumes that the oil peak is far off and that technology will allow us to make a smooth transition to the next energy economy (and solve other related problems that threaten to annihilate us such as global warming), then there is no need to worry about the effects of sudden demand destruction in the oil markets. But, if the peak arrives soon, say, within the next 10 to 15 years, then no bloodless abstraction such as "demand destruction" will be able to obscure the fact that it is people who are going to get destroyed, and lots of them.


Anonymous said...

I take it you think the Capital One commericals are incorrect, and the pillagers actually do have a future.

Anonymous said...

There's no evidence, actually, that the peak has not already occurred or won't occur this year, 2006. (It is famously seen only in hindsight. Thus it is too soon to say that 2005 wasn't the peak year). Some reports say that the peak for conventional oil production took place in 2004! That's not synonymous with the total peak, but it's an indication to me that the total peak is close at hand. Given this, the notion that we have 10 or 15 years before peak seems optimistic, even if it, too, is too close at hand to help us avoid destabalizating demand destruction.

What I'm saying, actually, is that your perspective on demand destruction --as a societally-destabalizing hardship for millions of people-- seems right on. And as other articles have pointed out, much of the USA population, at least, has very little leeway in the amount of oil consumption they can let go of (e.g., for commuting to work, for affording food, and for heating their homes) without triggering big destabalizing forces in the USA culture/economy as a whole.

I think this means that pillagers do have some sort of future --even if it's ultimately at the receiving end of another destabalizing factor: a shotgun blast.

Anonymous said...

I think that the peaking of conventional oil production is important. There is no substitute for conventional oil when you look at the cost to extract it. Demand destruction for conventional oil is occuring. Most people reading this blog are probably in a position where they do not feel it much, but the effects of the conventional oil peak are being felt by poorer people in poorer countries.

Anonymous said...

Even during a famine, there is a balance in demand and supply of food. Some just don't eat and starve to death (according to economists, this is called 'DEMAND DESTRUCTION').

When there is oil shortage, some will freeze to death and some will starve to death -- it is that simple -- that is how you destroy demand.

Should we have famines? May be we should starve all economists to death!!

Romesh Chander

Anonymous said...

There are multiple milestones on the way to the world's oil production rate hitting a peak. One of them is that conventional light, sweet crude oil (from pressurized oil fields on dry land in a moderate climate) will (has?) peaked before the sum of the remaining conventional oil plus harder-to-get (offshore, deep water, polar, etc.) and harder-to-refine (heavy crude, tar sands, shale oil) combined production rates peak and go into decline.

During this phase after conventional light, sweet crude oil production rates peak and before total oil production rates peak there will be price increases and price instability (already happening now) inflation (already happening now) wars over oil (already happening now.)

Based on the 200 day moving average price of light crude oil on NYMEX having gone up with no signs of going down continuously since the start of 2004 it is quite possible that we have reached this intermediate stage.

All hell has yet to break out as we are still able to raise total oil production rates.

Anonymous said...

Another point:

Oil is "scarce" largely because POLITICS gets in the way of proper use of resources.
Cases in point -
1. ANWR.
2. Iran.

Stopping the drilling in ANWR and Iran's threat to cut off oil both increase the price of oil. The first case, $600 billion worht of oil (whose revenues could help US government quite a bit) has been taken off the table. So too offshore drilling, which holds about $1 trillion worth of gas off the Cali coast, etc.

oil is high right now because of a threat of future supply disruption - Iran. Again, politics creates that threat. In Nigeria the supply disruption is real.

Governments have (ab)used their powers to nationalize or extort the wealth of oil producers for their own benefits. The consequence of that is that in many countries, the investments are not made to improve the extraction and use of oil.

It's a sad fact that oil is so valuable, it encouarges power-mongering (eg Iran and Chavez in Venezuala), this creates socialism in many countries, which leads to poverty. Ironically, most OPEC nations are poor nations, while resource poor countries like Japan, Taiwan, Ireland, South Korea, now do well.

The world's lack of faith in the free market is bizarre and disproven by history time and time again ... why do so few people turn away from the engine of prosperity and cling to philosophies that produce misery tyranny and poverty?

this disagreement with the 'market' is mistaken:

"Market participants are unlikely to see the peak coming. This means that prices will only start to signal that alternatives are needed for oil long after it is too late to prevent tremendous disruptions."

if the 'market' disagrees with you, CONSIDER AT LEAST THE POSSIBILITY THAT YOU ARE WRONG AND THE MARKET (wisdom of crowds) IS RIGHT.

In any case, the market has gone from signalling long-term crude oil prices of around $30 3 years ago, to nove showing long-term energy prices in the $55+ range (looking out 3-5 years). Big change and a signal to oil companies to invest.

Anonymous said...

Patrick's last sentence is interesting: ...signalling oil companies to invest. Indeed, they are *not* increasing investment in exploration, nor making *any* investment in new refining. They are investing in known reserves - by acquisition - and transport, particularly pipelines. There has not been a giant/super giant oil discovery in 20 years anywhere in the world. Saudi Aramco has spent billions on exploration and not found any signicant, producible new reserves since the '70s.

The oil companies already know that the game has changed.

Anonymous said...

Patrick's penultimate sentence is also a magnificent giveaway, undermining most of his previous argument. If "the market has gone from signalling long-term crude oil prices of around $30 3 years ago, to [now] showing long-term energy prices in the $55+ range (looking out 3-5 years)", then
1. "long-term" in market terms is clearly not long enough for market signals to produce the technological and organisational changes required to overcome problems associated with decreasing supply without 'demand destruction'
2. The market , 3 years ago, was giving an incorrect price signal, by a factor of 80-100 percent. Which is quite a lot, IMO

Anonymous said...

how to achieve demand destruction.

The key issue seems to be how to make the japanese export the same quality finished goods, yet live a very rudimentary life style that doesn't make unjustified demands on world commodities, in other words, the koreans and japanese should be made to produce the same quality export goods but their lifestyle should be reduced to that of ethiopia and somalia. They should only need to import just enough world commodities to justify assembly of finished goods and parts for export to the west.

They should not be driving Audis and BMWs or flying to europe and america by the millions for luxury vacations, yet they should still be able to stamp and cast their toyota and honda parts and send them to the west for final assembly. How can this be made to happen? The point is, their excessive demand on basic world commodities is not legitimate or justified considering western interests, and the value of their finished goods.

China, japan, and south korea don't need to consume half the world's oil supply just to assemble large flat panel TV's or to stamp and cast car parts, or to produce the plastic junk for walmart's shelves. If china, japan and south korea are denied unjustified oil and commodity imports, the west will once again become the only market available for oil exporters of the middle east to sell into.

The USA, canada, the UK, new zealand, australia, amd mainland europe can combine military power to permanently blockade all oil tanker and raw commodity imports into china, japan, and south korea that are in excess of that needed for the legitimate production of finished export goods for the west. This demand destruction will allow oil prices to fall dramatically and the problem of permanent depletion of easily extracted oil will be pushed considerably into the future.

The western military should be rationalized by restructuring itself into a biased profit making organization that rations the flow of commodities and finished goods on the worlds oceans and thereby adjusts the economies of china, japan and south korea to best serve the interests of the west. The current occupation of iraq is a clumsy attempt to regulate the influence of china, japan and korea in the oil rich regions around the persian gulf. A much more comprehensive plan should be implemented to modify the oil and commodity consumption patterns of china, japan and korea.

It's interesting to know that china, japan, and korea collectively own a quantity of dollar denominated assets that approach the size of the GDP of the united states, the US government should simply repudiate those dollar claims in order to prevent china, japan and korea from retaliating by disrupting dollar denominated markets.

Michael Ejercito said...

Should we have famines? May be we should starve all economists to death!!

Economists who are predicting peak oil are simply describing the way things are , not the way things people wish them to be.

Do not blame the economists for telling the truth.

Anonymous said...

Thank you for this post.

Anonymous said...

I just want to say that I wrote a promotion for a resource newsletter about peak oil, back in late 2005.

The opening line, "One of the most devastating economic events in history will happen on July 2, 2006. That's our best guess..."

The promo was a huge hit, even though we took a stab in the dark at the date. Or should I say, we extrapolated based on research.

Never imagined we'd get it so right. But in hindsight, I think it's clear we pegged it not just to the month or date... but possibly to the hour (said only half tongue-in-cheek.)

Peak oil has come and gone. Now we're enjoying the rush of the breeze past our faces, as we fall off the cliff.